Premium #257 – Brazil starts to negotiate

First, on December 22, we here Brazil’s President will not consider “transfer ownership”. The next day, Brazil's Workers Party called any deal between Embraer and Boeing "an aggression against national sovereignty." But despite the nationalistic knee-jerk reaction, the reality is dawning in Brazil. Absent a deal with Boeing, Embraer will not compete as well against the combination of Airbus and Bombardier. Boeing knows this, which is why it started the conversation. One can imagine the scenario Boeing is painting in Brasilia. They do not need to be as effusive in San Jose dos Campos because the management at Embraer can see right away how the market will shift. The Brazilian state will want to extract the maximum leverage from any deal with Boeing. Politics demand it. President Temer must juggle nationalist demands for honor and dignity with reality on the ground at Embraer. That means, in essence, that Boeing has to end up paying top dollar for access to the commercial aviation side of Embraer. While Brazil will want to keep its hands on the control of the military side, it will be delighted to have Boeing “partner” on sales campaigns for the KC-390. Already the President is saying he welcomes an injection of foreign capital. Of course he does, because Brazil cannot afford to fund Embraer’s development. As the Boeing and Embraer circle each other and try to figure out how to join forces at the right level of control and pricing, another dance is probably taking place someplace else. Airbus started the music. It’s deal with Bombardier on the C Series set Boeing off. The vulnerability of the MAX7 is plain to see. Boeing can’t fix it – even with the US Department of Commerce on its side. The MAX7 sales are anemic. The ITC didn’t ask the obvious question when Mr. McAllister voiced his appreciation of how Southwest built their business on the 737-700. That question would have been this: “If the 737-700 size is so good for Southwest - after all, they operate 510 of them – why have they only ordered 30 MAX7s compared to 158 MAX8s?” Mr. McAllister’s response would be interesting to hear. Moreover, of the 58 MAX7s on order, there are only two airlines on record – Southwest in the US and WestJet in Canada. Airlines beyond the reach of the US Department of Commerce’s protective ways have near zero interest in the MAX7. No wonder Boeing wants a deal with Embraer. The Embraer E2 program, once it achieves EIS, will also start to eat into the MAX7 market, just like the C Series. Airbus and Boeing have been watching this for years – yes, years and treated the C Series with open disdain. Airbus got the better of the deal because of the growth potential of C Series. They could introduce a new technology airplane with a stretch to hurt the MAX8, but Boeing can’t stretch the E2. The CS' recent market success despite aggressive pricing by Airbus and Boeing show it is the right plane in the segment. When the E2 reaches EIS, it will also see order growth. The E2 orders will be to replace older Airbus and Boeing models below 130 seats. Airbus saw the reality for what it is and got a screaming deal with a battered Bombardier. It was a classic first mover advantage. Not unlike offering American Airlines the A320neo in 2011. The stakes are big and President Temer seems to understand this already. He must now move the rest of the Brazilian electorate to the reality. So, Boeing has to up the price. Boeing also must talk (a lot) about investing in Brazil. Boeing has to say how wonderful the KC-390 is and how Boeing will get this aircraft into the USAF. And that other dance? It is where Airbus and Bombardier, already holding hands, now decide to broaden their relationship. No longer is it going to be limited to the C Series Partnership. Airbus is going to go for the entire aerospace business – because they have to because Boeing is now forcing their hand. The sweetheart deal Airbus got on the C Series might now change radically. Bombardier’s shareholders and bondholders are as happy as are the shareholders and bondholders at Embraer. The big duopoly has to absorb the small duopoly to compete. There are several questions for the Airbus/Bombardier engagement: What happens to the CRJ? How do they overcome a monopoly with the ATR and Q400? Are the rail assets of interest? But having already created a relationship, it may be easier to overcome hurdles like these. 2018 looks like being a very interesting year for the aerospace industry. Consolidations and more M&A deals are likely to follow.

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